PHLX Denied Six-Figure Recovery Against And Suspension of Disgruntled Member

March 30, 2009

Richard B. Feinberg became a member of the Philadelphia Stock Exchange (PHLX) in 2003 by purchasing a seat on the Exchange for approximately $18,000. In January 2004, the PHLX converted from a nonprofit mutual organization to a for-profit corporation through a process called demutualization. As a result of this process, each of the PHLX's seat-holders became shareholders, with each seat converting into 100 shares of common stock. Feinberg's seat was thus converted into 100 shares of PHLX common stock. 

If Only I Had Known (but did she?)

In the fall of 2004, Feinberg decided to sell his shares of PHLX stock. He initially offered the shares for $25,000 but was unable to attract a buyer. After lowering his price to $20,000, Feinberg sold the shares on December 1, 2004; but did not know who the buyer was until his offer was accepted. The buyer was Benton Partners II LLP ("Benton Partners"), which, at the time of the sale, was controlled by I. Isabelle Benton, a governor on the PHLX Board of Governors and a member on the PHLX's executive, options, floor procedure and strategic alliance committees. Around the time Benton Partners purchased Feinberg's shares, the PHLX was in private negotiations to sell all or part of the Exchange. 

Shortly before Benton's transaction with Feinberg, the PHLX had begun negotiations with Archipelago Holdings LLC ("Archipelago"), which apparently offered the PHLX $50 million to purchase all of the PHLX's outstanding stock (said offer subsequently was rejected). The PHLX announced a partial sale of its stock in June 2005 to Citadel Derivatives Group, LLC ("Citadel") (with whom negotiations had apparently begun in the fall of 2004) and Merrill, Lynch, Pierce, Fenner & Smith, Inc. ("Merrill Lynch").  Under the terms of this deal, Citadel and Merrill Lynch each obtained a ten-percent stake in the PHLX, with a potential option to double that stake. The record is unclear on how much Citadel or Merrill Lynch paid to obtain these stakes. Two months later, the PHLX announced another sale of its stock. In this second transaction, the PHLX sold a ten-percent stake to Morgan Stanley & Co., Inc. for $7.5 million and a five-percent stake to each of Citigroup, Credit Suisse First Boston and UBS Securities, LLC for $3.75 million. Similar to the deal announced in June, each of these investors retained an option to double its interest. At the same time it announced this second transaction, the PHLX also announced its intention to implement a share buyback offer, pursuant to which the PHLX would offer to repurchase its shares at $900 per share - a price $700 per share greater than the price at which Feinberg sold his shares to Benton Partners.

Federal Lawsuit Against Benton and Benton Partners

In September 2005, Feinberg sued Benton and Benton Partners for securities fraud in the U.S. District Court for the Eastern District of Pennsylvania, alleging that Benton Partners violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and that Benton was liable as a control person of Benton Partners under Section 20(a) of the Exchange Act.  Feinberg claimed that Benton Partners had failed to disclose three pieces of material nonpublic information: 

(i) that, in November 2004, the PHLX had begun negotiations to sell the Exchange to Archipelago, 

(ii) that, in the fall of 2004, the PHLX had negotiated with Citadel to sell a stake in the Exchange, and 

(iii) that, in 2002, Keefe Bruyette & Woods had performed a valuation of the PHLX that placed the PHLX's value at between $250 and $350 million. 

Feinberg alleged that, had he been aware of this information at the time of the sale, "[he] would not have sold the 100 shares of PHLX stock to anyone for $20,000." 

Feinberg served a number of discovery requests on various nonparty witnesses, including the PHLX and certain affiliates. Feinberg first sought documents informally from the PHLX, and after negotiating a confidentiality order, the PHLX produced certain materials. Feinberg also issued formal discovery subpoenas to the PHLX and individuals who appear to have been PHLX officers and governors. The PHLX largely fought these subpoenas, and other than successfully conducting one deposition, Feinberg was unable to obtain much of the discovery he sought from either the PHLX or its affiliates. Following trial on March 4, 2008, after Feinberg presented his case in chief, the Court entered a directed judgment in favor of Benton and Benton Partners.

The Bill --- Gratuities Not Included

One month after the district court entered the directed judgment, the PHLX sent Feinberg an invoice for $470,285.51 in legal fees and expenses the PHLX incurred during the Benton lawsuit. Of these fees and expenses, $320,281.31 were attributable to indemnifying Benton for the costs she incurred defending herself and Benton Partners during trial and $150,823.05 were attributable to responding to Feinberg's third-party discovery requests, preparing witnesses for deposition and trial, and "generally represent[ing] PHLX's interests with respect to the litigation." The PHLX stated that it was issuing the invoice pursuant to PHLX Rule 651, which requires members to repay legal costs incurred by the PHLX in defending itself or its board members from certain suits that are "related to the business of the Exchange."

Feinberg objected to the invoice and filed a brief in opposition with the Special Committee. Feinberg argued that Rule 651 did not apply to expenses incurred responding to third-party subpoenas, that he did not name the Exchange as a party to his suit, and that his suit against Benton was not "related to the business of Exchange." The Special Committee held a hearing and, on July 17, 2008, issued an opinion rejecting Feinberg's objections. The committee gave Feinberg ten days in which to pay the amount due or to agree to a payment schedule, and ordered that he be suspended from the PHLX pursuant to PHLX By-Law Article XIV, Section 14-5, if he did not meet the ten-day deadline.

Feinberg appealed the PHLX's opinion to the Securities and Exchange Commission. In the Matter of Richard B. Feinberg, (1934 Rel. No. 59577, Admin. Proc. File No. 3-13128 / March 13, 2009).

Let's Read the Rule

Rule 651 states that "[a]ny member . . . who fails to prevail in a lawsuit or other legal proceeding instituted by such person or entity against the Exchange or any of its board members, officers, committee members, employees, or agents, and related to the business of the Exchange, shall pay to the Exchange all reasonable expenses, including attorneys' fees, incurred by the Exchange in the defense of such proceeding . . . ."

The SEC stated that the question before it was not whether the PHLX was required to indemnify Benton, but whether the PHLX was entitled to reimbursement from Feinberg under Rule 651.  The PHLX acknowledges that the scope of its authority under Rule 651 is not limitless, conceding that the rule would not apply "to a private tort claim between Mr. Feinberg and Ms. Benton arising from an auto accident, even if Ms. Benton 'was an official of the PHLX' at the time of the accident." PHLX should not be entitled to reimbursement for a suit where the only connection to the Exchange is that the defendant just happens to be an official of the PHLX. In considering the facts, the SEC found that Feinberg's suit was still not sufficiently connected to the business of the Exchange. Although Benton's employment at the Exchange may have been a means by which she had access to inside information, she acted for her personal interests, and not on behalf of the Exchange, in purchasing the PHLX shares, which was the subject of the litigation between Feinberg and Benton.  As such, the SEC set aside the imposition of  $464,418.51 in fees and expenses and suspending Feinberg's membership.

Not Participating

In noting the voting by the members of the SEC on this case, the official reports states:

By the Commission (Chairman SCHAPIRO and Commissioners WALTER and PAREDES; Commissioners CASEY and AGUILAR not participating.)

As reported in on March 18, 2009, the United States Second Circuit Court of Appeals gave a second life to Standard Investment Chartered,Inc. (Plaintiff-Appellant) v. National Association of Securities Dealers, Inc., a/k/a NASD, NYSE Group., Mary L. Schapiro, Richard F. Brueckner and Barbara Z. Sweeney (Defendants-Appellants) (07-3372-cv), which was then on appeal from the July 13, 2007, judgment of the United States District Court for the Southern District of New York; See, Standard Investment Chartered, Inc. v. NASD et al., 07 Civ. 2014, 2007 WL 1296712 (S.D.N.Y. May 2, 2007) (Shirley Wohl Kram, District Judge), dismissing, for failure to exhaust administrative remedies, a lawsuit challenging aspects of the merger of the regulatory functions of the National Association of Securities Dealers and the New York Stock Exchange, which was approved by the Securities and Exchange Commission.

As reported in the New York Times, "S.E.C. Choice is Sued Over a Merger of Regulators" (Stephen Labaton, January 11, 2009), a second lawsuit naming NASD, Schapiro, and others was filed in federal court in December 2008. :

"Our cases raise questions about the transparency, truthfulness and candor of the NASD and its leadership in a major financial transaction with its own members," said Jonathan W. Cuneo, the lead lawyer in both cases for the member firms. "It's certainly ironic that the case involves the NASD, which is charged with policing those values in others."

. . .

"This case is about a corporate transaction effectuated by deception," the complaint in the latest case said. "The officer defendants stood to gain substantially by the transaction, in terms of enormously higher compensation and benefits, vastly elevated prestige and powers resulting from the virtual monopoly regulatory authority created by the transaction, and the higher degree of control over the board of the consolidated entity."

After the merger, Ms. Schapiro's total compensation rose to more than $3.1 million, from almost $2 million. The pay package, while not outsize by Wall Street standards, is large for a nonprofit organization. Mr. Perone, the Finra spokesman, said the raise was the result of Ms. Schapiro's promotion to a higher job. He said her predecessor had received about $6 million in compensation. Other top executives at the new entity received pay increases of around 20 percent after the merger.

Too Close to Comfort -- Or Just Me?

There is no stated reason for the non-participation of Commissioners Casey and Aguilar. What does leave me a bit uneasy is the participation of Schapiro and Walter -- not saying it's wrong, but, I am discomforted given that

  • the allegations in Feinberg involve claims of impropriety involving the sale of the PHLX (a major financial transaction involving a market participant);
  • Feinberg argued that he was underpaid the fair market value of his shares because of contemporaneous PHLX negotiations that he was unaware of;
  • the NASD/NYSE merger into FINRA involved a major financial transaction involving a market participant;
  • the FINRA class actions allege that FINRA members were underpaid as part of a scheme;
  • the two pending class actions name three self-regulators (NASD, NYSE, and FINRA) and a sitting SEC Chair who headed two of those regulators;
  • the FINRA class actions were pending when Feinberg was on appeal to the SEC; and
  • participating Commissioner Walter was only nominated to the SEC in June 2008, prior to which she was a senior executive at NASD for over a decade.
Feinberg was not a lawsuit filed against a self-regulator, whereas the two FINRA class actions are; but the inescapable fact is that the PHLX sought to expressly recover costs it said were "related to the business of the Exchange." Moreover, PHLX sought to impose a regulatory sanction by threatening to suspend Feinberg's membership in retaliation for non-payment of the demanded fees.

Feinberg and the FINRA class actions are so uncomfortably similar as to have warranted a serious consideration of recusal by Schapiro and Walter--if for nothing more than appearance's sake. Although the SEC's opinion favors Feinberg, there is so much discussion as to why this is not the case here and how that isn't precisely what is written in this rule, that one wonders if some of the distinguishing could ultimately be seen as positioning for a future situation involving aspects of the pending  NASD/NYSE/FINRA matters. Given all the turmoil circling around regulators these days, I think Schapiro and Walter would have done themselves and their organization a far greater service by not participating in this decision.   Of course, I now wonder why Casey and Aguilar stepped aside.